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A change in the price of a commodity alters the quantity demanded by consumer. This is known as price effect. However, this price effect comprises of two effects, namely substitution effect and income effect. Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect. Again, let us consider a two-commodity model for simplicity.
Assume that the price of one commodity falls. Due to an increase in the real income, the consumer is now able to purchase more quantity of commodities. This is known as income effect. Hence, according to our example, the decline in the price level leads to an increasing consumption.
This occurs because of the price effect, which comprises income effect and substitution effect. Now, can you tell how much increase in consumption is due to income effect and how much increase in consumption is due to substitution effect? To answer this question, we need to separate the income effect and substitution effect.
Let us look at figure 1. Figure 1 shows that price effect change in P x , which comprises substitution effect and income effect, leads to a change in quantity demanded change in Q x. The splitting of the price effect into the substitution and income effects can be done by holding the real income constant.
When you hold the real income constant, you will be able to measure the change in quantity caused due to substitution effect.
Hence, the remaining change in quantity represents the change due to income effect. In figure 2, the initial equilibrium of the consumer is E 1 , where indifference curve IC 1 is tangent to the budget line AB 1. Assume that the price of commodity X decreases income and the price of other commodity remain constant. This result in the new budget line is AB 2. Hence, the consumer moves to the new equilibrium point E 3 , where new budget line AB 2 is tangent to IC 2.
Thus, there is an increase in the quantity demanded of commodity X from X 1 to X 2. An increase in the quantity demanded of commodity X is caused by both income effect and substitution effect. Now we need to separate these two effects. In order to do so, we need to keep the real income constant i.
At the same time, the new parallel price line A 3 B 3 is tangent to indifference curve IC 1 at point E 2. This means that an increase in quantity demanded of commodity X from X 1 to X 3 is purely because of the substitution effect. We get the income effect by subtracting substitution effect X 1 X 3 from the total price effect X 1 X 2.
Figure 3 illustrates the Slutskian version of calculating income effect and substitution effect. In figure 3, AB 1 is the initial budget line. Suppose the price of commodity X falls price effect takes place and other things remain the same. Now the consumer shifts to another equilibrium point E 2 , where indifference curve IC 3 is tangent to the new budget line AB 2.
This is the total price effect caused by the decline in price of commodity X. Now the task before us is to isolate the substitution effect. What we are doing here is that we make the consumer to purchase his original consumption bundle i.
In figure 3, this is illustrated by drawing a new budget line A 4 B 4 , which passes through original equilibrium point E 1 but is parallel to AB 2.
Now the only possibility of price effect is the substitution effect. In Slutsky version, the substitution effect leads the consumer to a higher indifference curve.
Sign in or sign up and post using a HubPages Network account. Comments are not for promoting your articles or other sites. This is a very good work but the equilibrium points arent consistent with their respective indifference curves.
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HubPages Inc, a part of Maven Inc. As a user in the EEA, your approval is needed on a few things. To provide a better website experience, owlcation. Please choose which areas of our service you consent to our doing so. Sundaram Ponnusamy more. Income and Substitution Effects of a Price Change A change in the price of a commodity alters the quantity demanded by consumer. Substitution Effect Let us consider a two-commodity model for simplicity. How to separate the income effect and substitution effect?
Figure 1. To keep the real income constant, there are mainly two methods suggested in economic literature: The Hicksian Method The Slutskian method. The Hicksian Method Let us look at J. Questions must be on-topic, written with proper grammar usage, and understandable to a wide audience. It's very easy to understand Awesome explanation..
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The Hicksian Method and The Slutskian Method
A change in the price of a commodity alters the quantity demanded by consumer. This is known as price effect. However, this price effect comprises of two effects, namely substitution effect and income effect. Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect.